How to Use Tax-Efficient Funds to Your Advantage

If you don't know about tax-efficient funds, you may be paying more taxes than necessary and potentially reducing your long-term investment performance. The failure to apply the basic concepts of tax-efficient investing is among the biggest mistakes investors make. Learn how to use tax-efficient funds so you can keep more of your hard-earned money.

What Are Tax-Efficient Funds?

Tax-efficient funds are mutual funds or exchange-traded funds (ETFs) that generate lower relative levels of dividends and capital gains than the average mutual fund. Conversely, a fund that is not tax-efficient generates dividends and capital gains at a higher relative rate than tax-efficient mutual funds or ETFs.

Tax-efficiency is a concern primarily for investors who have taxable accounts. This is because dividends and capital gains distributions produced by funds that aren't tax-efficient are liable to be taxed. When these taxable gains and dividends are produced in a taxable account, the investor must pay taxes on them during that tax year.

Examples of Tax-Efficient Funds

Tax-efficient funds generate little or no dividends or capital gains distributions. Therefore, you will want to find mutual fund types that match this style if you want to minimize taxes in a regular, taxable brokerage account.

Here are examples of tax-efficient funds.

Growth stock funds: Growth stocks generally pay low or no dividends because growth companies will often reinvest their profits rather than share them with shareholders in the form of dividends.

Small-cap stock funds: Similar to growth companies, small-cap companies typically reinvest their profits into their respective businesses rather than paying out dividends to shareholders.

Index funds: Since index funds are passively managed, they generate fewer capital gains (that are then passed along to shareholders in the form of capital gains distributions) than funds that have a manager who actively trades stocks.

Municipal bond funds: An investor who wants to minimize taxes but also has an income objective can use municipal bond funds, which pay interest that is not subject to federal income taxes. Depending on state and local laws, certain municipal bonds might also be exempt from state and local taxes. For example, a New York City resident who owns New York City municipal bonds is earning income that is tax-exempt on all three levels of taxation.

Examples of Funds That Are Not Tax-Efficient

Large company stocks: Funds that invest in large companies, such as large-cap stock funds, typically produce higher relative dividends, because large companies often pass some of their profits along to investors in the form of dividends. Exceptions to this general rule of thumb include large-cap growth stocks.

Actively managed funds: You also need to be cautious of actively managed mutual funds because they tend to have higher turnover than passively managed funds. This means that the active manager tends to buy and sell the holdings more frequently than the passive manager does. Placing more trades increases the chance of producing capital gains distributions.

Bond funds: Most bond funds—other than municipal bond funds—pay income out of interest received from the underlying bond holdings, so they are not generally tax-efficient.

How to Know Whether a Fund Is Tax-Efficient or Not

The most basic way to know whether a fund is tax-efficient or not is by looking at the fund's stated objective. For example, a "growth" objective implies that the fund will hold stocks of companies that are growing, rather than focusing on stocks that pay dividends. A fund that has an objective of "income" is, by nature, attempting to generate income from dividends (stocks), interest (bonds), or both. Therefore, funds that have an income objective are not generally tax-efficient.

Example of Tax-Efficient Investing Practices

Let's say an investor has two different investment accounts:

• A 401(k), which is a tax-deferred account
• A regular individual brokerage account, which is a taxable account

Assuming that the investor was primarily seeking long-term growth (they have a time horizon of 10 years or more and want to grow their investments), they will hold the least tax-efficient funds in their 401(k) and the most tax-efficient funds in their regular brokerage account.

With this strategy, the dividends, interest, and capital gains produced by the inefficient funds—bond, active, and income funds—in the 401(k) will not produce current taxes for the investor. The tax-efficient funds—small-cap stock, index, and growth funds—in the brokerage account will generate smaller amounts of current taxable income (if any) for the investor.

The Bottom Line

Am investor would be wise to minimize taxes, which are a drag on the overall returns of a mutual fund portfolio. If an investor only has tax-deferred accounts, such as IRAs, 401(k)s, and annuities, there is no concern about tax-efficiency, because there are no current taxes owed while holding the funds in any of these account types. However, if an investor uses taxable brokerage accounts, they may try to concentrate on holding only index funds and ETFs there.

The basic lesson here is to consider the type of account you're using as you choose investments to hold within it.

The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.